How Wall Street bets on interest rates

Monday

Mar 17, 2014 at 6:00 AM

By Peter S. Cohan WALL & MAIN

I have often wondered how people like George Soros can make a profit of $1 billion by betting on the direction of a country's interest rates. Thanks to a series of interviews with a pair of Wall Street traders, I have a better idea of how it works — but not enough to get into the game.

My interviews — the two traders requested anonymity to keep their jobs — revealed that winning at this game depends on getting a whiff of the policy change ahead of most other traders, gaining deep insights into how those changes are likely to affect specific interest rates, finding mispricing based on the gap between market prices and those insights, and placing bets that will increase in value if those gaps are closed.

If you are interested in getting into this game — or more generally getting your hands on the tools that Wall Street traders use at a very low price — you might consider learning more about a software tool called Thinknum: These Wall Street traders used it to help them profit from their views on changing interest rates.

To understand why this might be interesting to anyone who needs money to get by during their lives, it is worth understanding how Mr. Soros made $1 billion betting on changes in Japanese interest rate policies in 2012 and 2013.

As the Wall Street Journal reported in February 2013, Mr. Soros was estimated to have made a profit of at least $1 billion by betting on a decline in the Japanese yen starting in November 2012 and continuing through last February. Mr. Soros had wagered successfully that Shinzo Abe would be elected Japan's prime minister and would take action to weaken the yen so that Japanese exports were boosted.

Not only did Japanese economic policy lower the yen, so did the efforts of traders like Mr. Soros to profit from that decline. Between November 2012 and February 2013, the yen lost about 20 percent of its value.

Mr. Abe discussed plans to drive down the yen, so traders added to their positions, lowering its value. The hedge fund bet on Abe-nomics helped drive the value of the yen down from 79 to the dollar in the middle of November 2012 to 93 in February 2013, according to the Journal.

The two traders I interviewed — who did not provide details of the size of their bets — made a profit of 13 basis points (100 basis points is 1 percent) by betting in January 2013 that the U.S. Federal Reserve would cut back on economic stimulus. If they had bet, say, $100 million, the 13 basis points would have translated into a $130,000 profit.

And the regression software available through Thinknum was an important part of that profit. As I learned in a January 2014 interview, Gregory Ugwi and Justin Zhen co-founded Thinknum (thinknum.com) as "a radically open web platform for financial analysis. We are bringing Web 2.0 to finance."

The traders expected the so-called yield curve to flatten, meaning that short-term interest rates would rise and long-term ones would fall "on back of stronger economic data and the Fed's first taper announcement — (causing) the curve (to) flatten into a sell-off."

While this was not a unique insight at the time, they were able to get ahead of the other traders. As they said, "A few traders saw the same thing happening, but not a lot, once a large proportion of traders saw that happening, the market priced to what will happen. We are able to make money trading this by being among the first to thoroughly understand this view and implement it."

To profit from the idea that the Fed would loosen monetary policy, they placed bets that would be more valuable if the five-year U.S. Treasury bond dropped in price, while the 10-year U.S. Treasury bond went up in value. They thought other traders would see the Fed's taper announcement "as a precursor for the Fed to raise interest rates. Once that happens, short rates would rise relative to longer-term rates. Therefore, an investor would do that trade if s/he felt the market wasn't priced appropriately for a Fed hiking cycle."

Specifically, the model they developed using regression analysis — a way to measure how much two variables move together — suggested that at the time they did their trade, the market prices were wrong and they should bet on that mispricing.

"We expected the rate movement to be no more than 150 basis points from the then-current levels. The historical relationship would hold over the time horizon we were looking at for the trade. We thought that the actual slope was 6 basis points too high compared to the predicted slope and that it should drop to historical levels," they explained.

How much of their 13 basis points in profit was due to Thinknum? They think it was a combination of the original idea, the tools they used to analyze the idea, its execution, and the management of its risks. Thinknum, they said, was integral to the success of that trade.

Peter Cohan of Marlboro heads a management consulting and venture capital firm, and teaches business strategy and entrepreneurship at Babson College. His email address is peter@petercohan.com